Author: subir

India’s demonetization: it’s like pixie-dust for bank balance-sheets

India’s demonetization: it’s like pixie-dust for bank balance-sheets

20161122_india-rupee-note_article_main_imageMany motives have been advanced for the great Indian demonetization of 2016. These include reducing the informal/untaxed “black-money” economy, removing counterfeit notes from circulation, making terrorist financing more difficult etc. Might there be another, unstated, reason apparent to central bank watchers? A subtle subterfuge to reduce the perceived level of non-performing assets (NPAs) at Indian banks.

By March 2016, Indian banks held 6 Trillion rupees (or 6 lakh crore) in NPAs. This amounted to 7.6% of their aggregate balance sheets as outlined by the RBI in its June 2016 financial stability report, up from 5.1% over six months. That large jump was the result of an Asset Quality Review initiated by the RBI. Indian banks had been using various devices to avoid classifying bad debts as NPAs. The RBI’s re-classification tore down this hall of mirrors. The RBI also projected NPAs could rise to 8.5% by March 2017.
Within two months, Raghuram Rajan had been removed from his post by the present Indian government. Eight weeks after that, Prime Minister Modi announced the shock demonetization of existing Rs. 500 and Rs. 1,000 notes.
Since then, 90% of the demonetized currency notes (14 Trillion rupees) have been deposited into the system. We can reasonably assume the bulk of these funds have remained in the banking system since withdrawal limits are in effect and large cash transactions are being discouraged.
If the denominator for NPA ratios has indeed risen from 79 Trillion rupees to 93 Trillion rupees. gross NPA ratios would fall to 6.4%. Just like that, we have a seemingly magical improvement in the credit quality of bank balance sheets.
Who knew a “digital economy” would have such fringe benefits?
(Also published as a letter by the Financial Times)
What should investors expect if Trump wins?

What should investors expect if Trump wins?

First, we think a Trump victory is quite unlikely. That said, the probability is not zero, it’s likely to be around 15-25%. We routinely analyze even less likely events and their impact on markets, so we have considered the reaction of markets if Mr. Trump were to win the general election.

There will be almost no place to hide from the initial volatility after an unexpected Trump victory. We expect significant turmoil in the financial markets and we believe that in the short-term (days/weeks) there will be few safe havens. Mr. Trump’s economic policies are so unconventional, and his temperament so mercurial, that we expect almost all sectors and asset classes to be somewhat affected by negative uncertainty. Precious metals may be the only asset that benefits from a flight to safety.

Bonds have traditionally served as a safe haven in times of turmoil. We believe bond investors should not remain sanguine if Mr. Trump does win the presidency. As a leveraged developer, Mr. Trump has had a colorful and combative history with lenders. His natural bluster has been intermittently aimed at bond markets during this campaign and the prospect of a Trump administration in control of the US Treasury is bound to spook bond investors. He has suggested he would unilaterally default on US sovereign debt (arguably not a novel position since the Republican congress toyed with a similar position in 2011) and seek to renegotiate principal amounts.

Mr. Trump has made combative comments about the Federal Reserve and its current policies. He has also expressed dissatisfaction with the current low interest rate regime. Taken together, these sharp, unusual policy views create immense uncertainty about how Mr. Trump would manage the credit and repayment of US debt, the government’s relationship with the Fed, and other issues of concern to the broader credit markets. We expect FX markets to exhibit a flight to perceived safety which historically has benefited the Swiss Franc and Japanese Yen. Uncertainty about bonds and rates will also hit real assets heavily dependent on credit markets. We do not expect real-estate to do well.

When it comes to stocks, we expect broad declines in the short term, but some sectors will be harder hit than others. The banking and financial sector is likely to see a steep decline in market sentiment and levels. Mr. Trump has made several negative statements about banks and their business models. Banks are also naturally leveraged and very sensitive to market sentiment. None of this augurs well for the banking or financial sectors.

Given Mr. Trump’s combative stance on trade and trade agreements, we would expect sectors dependent on imports/exports in their global supply chain to be battered. This includes consumer discretionary, technology, heavy industry, materials, and depending on precise global footprint, energy companies. In contrast, consumer staples should play their standard defensive role.

The immediate sentiment towards the defense industry is somewhat more uncertain. Mr. Trump has, at times, advocated a combative posture on national security and war matters. In almost direct contradiction, he has also proclaimed he would reduce the defense budget and the number of military bases overseas in line with his “America First” pledge. Defense contractors dependent on Pentagon contracts for services to troops overseas are likely to see sentiment and stock prices decline. Large defense manufacturers should decline as well since Mr. Trump has expressed skepticism about some expensive weapons programs (the F-35 in particular). The foreign policy and defense team Mr. Trump puts in place will determine how this plays out in the longer-term.

Beyond the initial few weeks and months, we expect much will depend on the composition of Mr. Trump’s administration and his demeanor during the transition. A prospective Trump administration caught up in balancing spending, debt, legislative priorities and political considerations would normally be constrained. However, Mr. Trump is likely to have a compliant Congress, with Republican legislative majorities and both Senators and Representatives eager to please the new force in American politics. It is impossible to make longer-range forecasts of what a Trump administration’s policies would look like, simply because we do not know his true priorities. We would advise investors to be extremely cautious about bargain-shopping in the immediate aftermath of a Trump victory.

Mr. Trump is unlikely to win the election, but in the event he did, we believe markets will react very poorly, at least initially. He is in many ways, the opposite of a traditional conservative politician, disdaining societal norms and conventional politics. Mr. Trump’s election would engender policy uncertainty on a scale not seen for decades, upending long-range business plans and reducing risk-appetites across the board. We would advise investors to exercise caution in the event Mr. Trump wins.

If a presidential candidate berates the Fed and no one pays attention, do markets still react?

If a presidential candidate berates the Fed and no one pays attention, do markets still react?


The Federal Reserve chose not to raise rates in September, despite speculation by many participants that they would. The decision went as we expected since the Fed is generally unwilling to move rates this close to a presidential election. As an institution, the Fed is very reluctant to take actions that could be interpreted as favoring one or another party. Absent a genuine crisis (as in 2008), Fed governors will heavily favor inaction in a presidential election year. Inaction in this instance means an expansionary monetary policy with very low rates, and this does indeed benefit the incumbent party. In our view, this is more accidental than deliberate.

For a number of decades, central bankers have walked a fine line. They are political appointees, but their decisions are supposed to be apolitical, and they enjoy a degree of independence not afforded to the heads of other government agencies. Like all senior government officials, Fed governors are politically attuned and they undoubtedly have personal political preferences. In a normal election year, with a more typical slate of candidates, Fed inaction might lead to quiet grumblings within DC circles. But this is not a normal election year.

We have seen Mr. Trump repeatedly attack the Federal Reserve chair, Janet Yellen, in very personal terms for keeping rates low. This has received very little attention among all the other political news and outrageous statements by Mr. Trump in this cycle. As with so many things this year, we cannot say whether or not berating Fed officials will become the political norm.

What we do know is that in most countries, the slightest hint of overt political “interference” in central banking decisions can spook markets. The enormous volatility of the South African Rand over the past year is a case in point. European markets saw similar gyrations during the months leading up to Mario Draghi’s succession of Jean-Claude Trichet.

Though berating the Fed is a small part of Mr. Trump’s political plank, we had to go back to Williams Jennings Bryant’s candidacies of 1896 or 1900 to find an instance where central bankers and monetary policy was dragged into an American political contest in such a way. And that was back when US dollars were backed by gold in a fixed amount. Neither the Nixon administration’s abrogation of the gold standard nor Mr. Volcker’s unremitting steps to control inflation elicited such personal invective. As long as Mr. Trump’s chances of winning the presidency remain slim, the market will remain sanguine. If the prospect of a Trump presidency were to become more likely, we expect the future monetary policy of the US to become an area of immense concern for the markets.

We have discussed interest rates extensively in our previous letters, and would like to briefly turn our attention to debt levels. Extremely high levels of debt were the primary cause of the 2006-2009 financial crisis and generally make for a riskier financial system. Though US households and enterprises continue to reduce debt (deleverage), global debt levels have continued to rise. Looking at World Bank and IMF data, we can see that global private sector credit now exceeds 2008 levels (measured as a percentage of GDP). US private sector debt, at almost two times GDP, remains higher than the global average. Much of the growth in global debt levels has come from China where debt to GDP levels have risen significantly. In 2008, the World Bank pegged Chinese domestic credit at 100% of GDP. By 2015, this had risen to 150%.

Chinese debt has not yet reached extreme levels, but the rate of growth is more extreme than it was in the US between 1994 (when debt was 120% of GDP) and 2008 (when it reached a peak of 206%). Economies linked to China in the Asia-Pacific region (Australia in particular) have seen increases of similar magnitude. Latin America and the Middle East round out the regions where debt loads have increased, but levels remain relatively low, around 60-70% of GDP. China remains the biggest risk, since it has a relatively immature credit market which has seen enormous growth in the past decade.

In the US, equities markets have remained in a tight range for the past three years as consumers chose to reduce debt and forgo spending. The S&P 500 has continued trading between 1800 and 2200 since 2014. This can also be partly attributed to the tail end of the business cycle, with no immediate catalyst for either further growth or a retraction. At this stage, we would expect inflationary concerns to force interest rate hikes, but inflation is low to non-existent as consumers continue to reduce leverage and remain price-conscious. For the Fed, this remains a challenging period, with few answers available in textbooks. That said, we expect the Fed will raise interest rates in December, after the election is safely settled, likely by 0.25%.

Investors face similar uncertainties and we continue to advocate for cautious asset allocation and a focus on defensive companies and sectors.

Brexit and the rise of Populist Isolationism

Brexit and the rise of Populist Isolationism


The second quarter of 2016 saw some stabilization in global equities after a very volatile Q1. But this calm was short-lived as the surprise results of the Brexit vote roiled markets in the last weeks of the quarter.

We do not believe the Brexit referendum in itself will have a significant impact on the global investment climate or opportunities for investors. Whether the UK remains within the EU, or exits and reaches an alternate trade agreement with the EU, is of marginal significance to investors, especially those outside of Europe. The initial impact is almost certainly restricted to the UK itself, which may see a political disintegration if Scotland dissolves the union with England and Wales. Peripheral EU countries with significant deficits/debt (Greece, Spain, Portugal, Italy) would see a further erosion in confidence as a large, economically vibrant member leaves the EU. The financial industry in the UK is bound to see some contraction if Britain exits. The large London-based banks employ tens of thousands of workers, many carrying European passports. If the pool of available recruits narrows, banks are likely to expand offices in other cities. Dublin, Frankfurt and Paris are obvious alternatives, Switzerland is another continental (though non-EU) option. An exit will also mean personal data that pertains to EU nationals can no longer be stored or retained in the UK. This will impact technology companies and data-centers, where, as a result, the UK will find its market in those industries contracting as well.

An exit would permit the UK to enter into trade agreements with third (non-EU) countries, including former colonies such as India, with far more freedom than it would enjoy within the EU. After a period of adjustment, we would expect the UK economy to resume whatever long-term trajectory it would otherwise have had given demographic trends. The costs of adjustment if Britain does exit will be extensive. Regulations will need to be re-written, border procedures modified, passports re-issued, and undoubtedly the political costs will be enormous. Bickering over the result is bound to continue for years and indeed decades. But these costs will not continue into perpetuity.

This is not to say Brexit is insignificant. From a political perspective, it is extremely significant. It is yet another important signal that the enormous economic, demographic, environmental and political changes of the past few decades have left large segments of many populations with a sense of discontent and loss. Since the collapse of the Soviet Union, we have seen enormous changes in rapid succession. Technology has disrupted many industries, expanded markets and brought new competitors to formerly isolated corners of the world. Online marketplaces allow distributors to reach virtually every person in an increasingly connected world with ubiquitous network access. It has also led to an increasing concentration of wealth in many parts of the world. Environmental and political upheavals have created a historically high number of refugees fleeing war or lack of opportunity. Urbanization is on the rise virtually everywhere with populations moving to cities in record numbers. Large cities across the world, and their surrounding areas, have become ever more diverse and globally inter-connected. Asia, with its enormous population, has historically been the center of global trade and economic activity. After almost two centuries of relative decline, Asian economies are seeing rapid, sustained growth.

Brexit reminds us that these changes are unwelcome to many. Rural areas across the world, industrial areas in the western world, those with nationalist sentiments, and older populations everywhere see an erosion of all that is familiar and comforting. Every crisis is seen as an indictment of an global elite forcing such changes on a reluctant population. In many ways these political forces are not new. They have always been with us and have simply gathered force as the impact of changes has risen. Every era of change and migration has encountered some degree of resistance; this includes prior periods of urbanization and industrialization across the world. Yet, even in the recent UK referendum, 48% of voters, and large majorities of younger voters, opted for remain.

The broader question for us as investors is whether or not political systems will be able to manage these changes peacefully and with as little disruption to daily activity as possible. Quite clearly, this is not the case in many parts of the world. Our view is that democracies have a better chance of managing such change peacefully. Yet, even in the US, the remarkable strength of an openly nativist and populist candidate such as Trump should serve as a warning. Enormous changes such as those we have seen over the past three decades have to be managed with care lest they alienate large portions of the population. That alienation, if allowed to fester, can create a window of opportunity for disruptive forces to attain power. This would pose a real risk to continued stability and the prosperity and well-being that accrue from it.

Quite apart from the significant political risks ahead, equities markets are at cyclically-high valuations. Bond prices too are at high valuations with interest rates at low levels. In our view, as value oriented investors, we see limited rewards for taking excess risk. Accordingly, we continue to advise clients to maintain a relatively conservative portfolio allocation, keeping in mind their long-term objectives and recommended allocation.




Subir Grewal, CFA                                    Louis Berger

2016 Q1 letter: Negative interest rates cap a rocky quarter

2016 Q1 letter: Negative interest rates cap a rocky quarter


The first quarter of 2016 saw market gyrations far rockier than many prognosticators had expected. A sharp drop in commodities prices and oil in particular sparked fears of a global slow-down and impacted all asset classes. Increased oil production in North America and the prospect of renewed imports from Iran led to expectations of a supply glut. Slowing economies in China, Brazil and Russia along with concern about potential slumps in the EU and US drove demand expectations down. Together, they combined to drive oil below $30 a barrel, causing great distress among the highest cost operators. Producers relying on deep sea projects (Brazil) and hydraulic fracturing (or fracking, in North America) have been among the most severely affected. Many small to mid-sized servicers and production companies are facing possible bankruptcy and have been liquidating assets. This has impacted the high-yield bond market (where many of these companies raised capital) and led to job losses in states where fracking had created small oil booms.

The commodity decline also caused steep retrenchment in various equity markets and drove the Federal Reserve to signal a pause in its plan to raise interest rates to 1% this year. The S&P 500 dropped as much 13% during the quarter and the MSCI Global stock index fell 11%. The S&P 500 has since recovered for the year, along with oil prices. In our view, the concerns that drove the asset market declines have not abated. Global growth continues to be weak and numerous markets are showing the signs of a waning seven year bull market. We would continue to urge caution when investing in risk assets across most markets.

Policy makers in several countries seem to have reached the end of their imagination when it comes to additional market stimulus. About 25% of the global economy now has negative interest rates. That includes the Euro-zone, Japan, Switzerland and Sweden. Banks are now being charged to maintain balances at the central bank. In a number of cases, banks have begun to pass these negative rates on to customers. This is bound to create great consternation. Depositors are not accustomed to being charged interest to maintain deposits. They may be used to seeing fees deducted from checking accounts, but most will be shocked to see savings accounts charged interest. In an environment where banks are already suspect in the eyes of many, this will lead to even more discontent.

From anecdotal evidence, customers have already begun to protest negative rates. We believe there is little sense in keeping rates negative for extended periods of time. In theory, it sounds reasonable to say there should be no zero-bound for rates. But humans are not theoretical creatures. We find being charged to keep our money in a bank rather strange, and customers will develop all sorts of behaviors to avoid this. These include keeping large sums of cash at home and purchasing safe haven non-financial assets (real-estate, precious metals etc.). Such behavior undermines the stated aims of negative rates, i.e. increasing the level of bank lending. The longer we maintain negative rates, the more distortions we introduce into the savings/money markets. In our view, this is not a policy that regulators should maintain for any period of time. It would be far more effective to apply fiscal stimulus in the form of government spending.

While markets have seemingly stabilized after a very volatile start to the year, we expect 2016 will see continued ups and downs with high risk assets remaining vulnerable to a price correction. We think this will present buying opportunities and we will continue to look for good entry points to buy equities we see as undervalued. We expect the market for bonds to remain very challenging for investors since rates are extremely low and corporate credit is deteriorating alongside the dip in global growth.


Subir Grewal                                                                                                 Louis Berger

2015 Q4 letter: Enter risk center stage

2015 Q4 letter: Enter risk center stage

After almost seven long years at effectively zero interest rates, on December 16th the Federal reserve raised rates 25 basis points and signaled a handful of similar increases to come over the course of the year. This move was not unexpected, and there are numerous caveats and complications since so many unconventional tools have been used over the past seven years. That said, the unequivocal signal is that there has been a “regime change” at the Federal Reserve. We are moving from loose monetary policy to tighter monetary policy. Regardless of whether or not the Fed’s moves actually raise rates across the yield curve or reduce lending, the signal has been received and will have implications for capital markets. For several quarters, we have sought to limit maturities in client bond portfolios in preparation for such a move.

We expect US equity markets to be weighed down heavily by the hikes over the course of 2016. Though 1% may not seem like much, a 1% rise in rates can reduce the present value of a future cash flow stream by over 10%. We also expect significant political and tax-related  uncertainty generated by an unusual election cycle in the US to affect stocks. Clients should expect the same headwinds to impact lower quality bonds as well.

Commodities have had a tough 2015 and we expect this to continue. Though we believe emerging markets (ex-China/Russia) will be one of the better performing assets of 2016, we do not believe this will flow into commodities markets which shall continue to be weighed down by reduced infrastructure build in China and dampened demand in the US and Europe. We have more detailed assessments for the year ahead in our top ten themes for 2016 (attached).

On the personal front, 2015 has been a fruitful year for us from both a personal and business perspective. Subir and Molly welcomed their second daughter, Rosalind into the world in June. We thank all our clients for their trust and confidence in us.





Subir Grewal                                                                                                 Louis Berger


2015 year-end review of themes

2015 year-end review of themes



Overall, we did well on our call for 2015. We were right on six, half right on three others and had one wrong. In general, the year lived up to our expectations of a low return environment with the anticipated Fed rate hike being the biggest influence.


  1. If not now, when? If not the Fed, who?: We expect the Federal Reserve to raise interest rates in 2015. We expect rates to gradually rise to a 1.0%–1.5% target, which would still be historically low. We were right on this call, but the Fed chose to wait till December to raise rates to 0.50%.Though the Fed has signaled rates will be raised to 1.25-1.50%, we are calling this one half-right.


  1. No one rings a bell at the top of the market: […] we expect major US indexes (S&P 500, Dow Jones, Nasdaq) to finish the year in negative territory. We were mostly right here, two out of the three indices ended down. The S&P500 ended 2014 at 2,059 and 2015 at 2,044; the Dow Jones dropped from 17,823 to 17,425; but the Nasdaq rose from 4,736 to 5,007.


  1. Emerging troubles: Emerging economies will continue to stumble in 2015, this includes resource dependent countries such as Russia and Brazil which have run into roadblocks as energy prices have fallen dramatically. […] We expect emerging market stocks and bonds to underperform developed markets this year. The MSCI Emerging Markets Index ended the year down 17%. The Chinese markets ended the year down over 10%, Brazil was down almost 16%, Russia down over 6%, and India down over 2%.


  1. Commodities weighed down: […] We see commodities finishing the year flat to negative. The Goldman-Sachs Commodities Index ended 2015 down over 30%.


  1. +  The trouble with oil: We do not expect oil prices to substantially recover in 2015. […] We expect brent crude prices to remain under $60 by year’s end. Brent crude started the year around $57 and ended 2015 around $37.


  1. Playing defense: For US equities, we believe defensive sectors, including healthcare and utilities will outperform others over the course of 2015. In any sort of correction, we expect enterprises providing essential goods and services to maintain profitability and revenues. Over-levered companies that have benefitted from speculative euphoria in recent years are particularly vulnerable to sell-offs in our view. We were half right on this call as healthcare outperformed the S&P 500 Index in 2015 (S&P Healthcare Index +5.8%) while utilities lagged (S&P Utilities Index -7.9%).


  1. + Euro Crisis, back to the future: […] Depending on outcomes, another round of brinksmanship will likely begin between Greek politicians, the markets and EU officials. Over the past few years, attitudes have hardened and we believe there is a real chance that Greece may be forced to, or choose to leave the Euro. Over the course of the year, we saw another round of concerns about Greece that led to weeks of tense negotiation. The Euro ended the year down about 10% against USD (from 1.20 to 1.07) partly s a result of continued concern about the longer-term prospects for the Euro-zone. Though economic issues have faded from view as a continuing refugee crisis absorbs headlines, we do not believe the Euro-zones strategic challenges have been dealt with.


  1. + Junk bonds get kicked to the curb. […] With rates rebounding (even marginally), we believe investors will find the reward that comes with high yield bonds no longer worth the risk.  We were correct on this call as high yield bonds suffered their first down year since 2008.  The Barclays High Yield Bond Index was -6.77% for 2015.


  1. × Growth in Renewables: […] With oil prices falling again, we’ve seen many renewable stocks follow suit, as sort of a knee jerk reaction by investors. We think this provides a tremendous buying opportunity, particularly in the YieldCo space where, like utilities, companies own a portfolio of newly constructed power projects with long term power purchasing agreements in place.  We believe we’re a bit early on this call, but for year-end list-scoring purposes we were wrong.  Renewable energy stocks had a negative return for 2015 impacted by falling prices for conventional energy. Renewables did however, outperform traditional fossil fuel energy stocks.  The Nasdaq Clean Edge Green Energy Index was -6.21% while the S&P 500 Energy Index finished -21.12%.


  1. The Russian question: […] We are bearish on Russia and expect the Russian market to underperform in 2015. The Russian market ended the year down 6%.


Q3 letter: China and Rates driving the market

Q3 letter: China and Rates driving the market

In our last letter, we stressed how economic turmoil in China could have far-reaching implications for the global economy.  Much of the past quarter’s market activity has been driven by this concern as global risk assets sold off in response to persistently weak data out of China.

We continue to view events in China as a top risk factor going forward despite aggressive attempts by Chinese authorities to prop up stocks and assure investors that markets are stabilized.  Much of the onshore Chinese market remains suspended and economic data points to substantial weakness. Stocks on the on-shore Shanghai exchange are about 30% overvalued when compared with the same securities trading in Hong Kong. Reports and analysis suggests the Chinese government continues to intervene in the market on a daily basis through its agencies and state owned enterprises. Restrictions on stock sales are still in place for many participants including company officers. The credit markets have grown significantly over the past few years, with private sector debt now at 227% of GDP (it was 116% in 2007). Most of this debt is related to real-estate in one form or another. In comparison, private sector debt in the US is roughly 180%. A rise in rates or the inability to roll over debt, would cause a significant shock to China’s private sector enterprises. Public sector debt levels appear more manageable, at 55% compared to 89% for the US. However, local governments are heavily reliant on off-balance sheet financing to fund infrastructure projects. If these vehicles were to fail and had to be bailed out, government debt could balloon to reach US levels. Given the Chinese market’s size, uncertainty in credit and equities markets has begun to affect perception of other emerging economies and has continued to depress commodity prices (where Chinese demand had once been the major growth driver).

Partly in response to these concerns, in September, the Federal Reserve chose not to raise interest rates (there was one dissenting vote). US stocks, which in previous years had rallied on dovish news from the Fed, reversed and sold off as market participants became spooked by Janet Yellen’s relatively gloomy press conference.  Most market participants had expected a rate rise and the Fed’s failure to deliver gave investors pause.

Despite some recent weaker-than-expected US employment data, we think it remains likely the Fed will raise interest rates at some point this quarter (possibly in November). Rates have been held steady below 0.25% for nearly 7 years now and the case for a punctuated normalization of rates grows stronger every month. We do not see room for meaningful raises next year as we would be in the middle of an election cycle (in an effort to remain non-partisan, the Fed prefers not to make major policy moves during election years). The Fed notes that levels of inflation are the biggest argument against raising rates and stubborn low inflation could potentially be a reason for them not to raise.

US equities markets remain approx 5% below the highs realized earlier this year and, despite an early October rally, we believe risks remain prevalent. We continue to urge US-based investors to maintain cautious allocations as valuations remain at cyclical highs and neither the business cycle nor the current interest rate environment are conducive to high risk investments in stocks or bonds.

While we think playing defense is prudent in this environment, increased volatility can often mean mispriced assets and buying opportunities, especially when sentiment turns negative and investors aggressively sell.  We will continue to closely monitor market moves and look to buy quality companies if they are sold indiscriminately.

As we are approaching the year-end, we remind clients to keep in mind calendar-year deadlines for 401k and retirement plan contributions. It may also be appropriate to review capital gains realized this year and discuss implications with tax advisors. As always, we would be happy to be part of the conversation.




Subir Grewal                                                                                                 Louis Berger

Chinese police haul in investment managers to probe “market volatility”

Chinese police haul in investment managers to probe “market volatility”

Over the course of this week, every move in global markets has been ascribed to “fear about China”. But it’s pretty clear that most of the media does not really understand what is happening in Chinese “markets” and the Chinese economy.

Markets are closed in China today and tomorrow, while Hong Kong will be open on Friday. On Wednesday, Chinese markets were down more than 4%, but came back to close about flat. Many observers assumed this was because state entities had been told to buy ahead of the big military parade to mark the 70th anniversary of V-J day (15-20 million Chinese people were killed in WW-II).

The biggest financial issues in China are related to local government debt (think municipal debt) and its rapid growth. Local governments have been on a debt issuing spree for years, which is necessary since they have limited taxing authority. Their revenues come from borrowing and selling land to real-estate developers. Those sales are complete with kickbacks and evictions of long-time residents. The problem is, real-estate development has dropped off a cliff so they aren’t buying land anymore. And this week, the Chinese authorities announced they would limit how much local governments can borrow this year (they’ve been talking about limits for three years and set some last year). That means local government revenues and spending are about to fall off a cliff as well.

The best commentary on Chinese credit markets comes from Michael Pettis. His latest post is: If we don’t understand both sides of China’s balance sheet, we understand neither.

But the stock market is what interests most people. So, here’s a scary fact about Chinese stocks. A number of Chinese companies trade on both the Shanghai stock exchange (on-shore A shares) and in Hong Kong (off-shore H shares). Their prices in Shanghai are, on average, 115% higher than the prices in Hong Kong. The shares represent the exact same economic interest in the exact same enterprise. Part of the reason is that so many Chinese stocks have suspended trading. Part of it is that China banned stock sales by major shareholders and executives for six months (through 2015). At one point in July, stock brokerage firms in China were instructed by the authorities not to accept any sell orders.

Whatever the Shanghai stock exchange is, it is definitely not a “market” in the sense that buyers and sellers meet and freely trade there. Hong Kong is much closer to a free market, which means if you believe HK prices are correct, Shanghai should another 50%. There are some “free-market” types who (mistakenly) think the H-share discount represents a “bargain” rather than reality. Or it may mean Rmb has a lot further to fall.

Yesterday, there were reports that Chinese regulators have called in numerous heads of investment management companies in an attempt to probe “market volatility”. Rumors are flying around about forcible detentions, in particular there are numerous stories about the Chinese head of the world’s largest fund of hedge funds, Man Group.

Li’s mobile phone was turned off when called on Monday. Chaoyong Wang, Li’s husband, said in a telephone interview that she is in a meeting with “relevant industry authorities” and he doesn’t know who they are. He said he spoke to her by telephone yesterday and today, expects her back home soon but does not know when.

Someone, somewhere is probably thinking, “I wish they were arresting hedge fund types here”. Remember, this is China. One senior manager told a colleague “If I don’t come back, look after my wife” as he left the office in response to a summons from the authorities.

It’s been an open secret that Chinese economic data, on unemployment, GDP and industrial activity is, shall we say heavily massaged. Lots of market participants have joked about this amongst themselves, but the implications are now being debated more seriously. I’ll let Chris Balding cover some of the more egregious issues:

No less than the second in command of China, the Premier Li Keqiang, has stated that Chinese GDP data is unreliable and “man-made”.  To put this in perspective, thecurrent Premier of China, second in command for the entire country, leading economic policy formulation, a Phd in economics, having spent essentially all his career inside public administration in various posts throughout China advises you not to trust GDP figures…

For more than a decade, Chinese unemployment spent most of its time bouncing between 4-4.2%.  Chinese economists became skeptical of the number and conducted a study estimating urban unemployment during their sample period reached 10.9%.

China has undoubtedly grown significantly over the long run and this is unquestionably good for China and the world. However, that is not the question.  The question is how reliable are Chinese GDP figures.  I believe as a baseline case from my own research alone, real Chinese GDP would need to revised downward by a minimum of 10% or approximately $1 trillion USD.  Add in other known problems and I believe the number could go as high as a downward revision of 30% of real GDP.  Think of it using a simple scenario, let’s assume every year since 2000 China has overstated GDP by 1%.  In other words, 10% is in reality 9%.  That would imply that today, China needs to revise current real GDP downwards by approximately 16%.  This would still mean that China has grown significantly but also, as a mountain of clear evidence indicates, Chinese GDP growth has been overstated. Finally, it is important to note that lots of little numbers are clearly off but all these little numbers add up to big changes especially when added up over time.

Compound interest can work against you folks.

A number of people are saying: All eyes on Chinese markets on Monday.

Dead Cat Bounce: Intra-day swing of 700 Dow points, ending down 200

Dead Cat Bounce: Intra-day swing of 700 Dow points, ending down 200

Futures this morning were up over 500 points, most of the trading during the day was above the 16,000 level between 250 and 400 points up. But we’ve closed at 15,666, the lows of the day.

Though yesterday’s numbers were eye-popping, today is arguably going to create more jitters. Big intra-day swings that end on lows scare traders. Though China and Japan were down, most of Europe and Asia was up. So the stage was set for an uptick in the US. Which reminds me of the senior equities trader who once told me “Europe does nothing at all till 1pm when the Americans come in to set the tune”. The negative close means the three largest markets, China, Japan and the US closed down today.

There’s the inevitable talk of painting the close. And there is the competing view that the morning session was just a dead cat bounce.

The real story is that Chinese over-investment in infrastructure and capital goods is grinding to a halt (they’ve built more roads, rails and apartments than they need). It’s all fueled by large increases in borrowing which is what causes most bubbles. Given the size of the Chinese economy, this has had an impact on resource prices (who is going to use all that oil and iron). At the margins, this will impact US businesses, especially the global behemoths. There are some parallels to the US situation in 1928, also coming at the end of a period of extensive capital investment (also in railroads) and when the US was emerging as a major economic powerhouse.

The backdrop is that US stocks are at cyclically high valuations, at least as measured by longer-term ratios like CAPE. This coupled with a 7 year long rally means a lot of people are rightfully wondering whether stocks can go higher.

As an aside, over 80% of stocks on the Shanghai exchange were untradable yesterday. Many of them because they hit the daily limit of a 10% fall in prices, the rest are suspended at the request of company management.

The real risk is China, not Greece – 2015 Q2 Letter

The real risk is China, not Greece – 2015 Q2 Letter

Two inflection points long in the making appear to have arrived simultaneously over the past few weeks. In Europe, negotiations between Greece and Euro-zone countries that have lent to Greece appear to have broken down; and in China, the stock market has taken a remarkable tumble. In itself, the Shanghai market’s steep fall is not surprising or remarkable (this was a market which had risen 150% over the previous year), but it is interesting in terms of what it portends for other markets and factors in China.

The various actors in the Greek/Euro crisis have indulged in brinksmanship for a number of years. The ECB, Euro-zone countries and the Greek government have stumbled from one crisis to the next, taking action only when forced to do so. And when they have acted, the result is to defer rather than reach resolution. It is clear to us that no final resolution of Greece’s sovereign debts can be made without some debt relief. The Greek economy has shrunk enormously under the weight of uncertainty and austerity policies. None of the modeled targets for growth have been met and Greece’s debts are now a larger multiple of Greek GDP (180%) than ever before, largely because of the sharp decline in GDP. A sudden growth spurt may solve that, but given high unemployment, it is difficult to see that materializing without some level of debt relief to lower the amount of the outstanding loans and interest payments. In reality, the only thing that has been achieved thus far is that Greek loans have been moved from the balance sheets of European banks to the balance sheets of European nations. European (and international) banks that lent to Greece, knowing the risks, were bailed out. There has been no such deliverance for Greece itself, and, despite frantic 11th hour negotiations, we do not expect one in the coming days.

A crucial factor that has made the crisis much worse for ordinary individuals in Greece is the absence of a pan-European deposit guarantee scheme. Bank customers in the US have enjoyed a federal guarantee for their deposits since the 1930s. This guarantee currently applies to the first $250,000 on deposit at an FDIC covered institution and has been the primary reason the US has avoided widespread bank runs by retail customers for the past 80 years. In contrast, deposit guarantees and guarantee funds in Europe are run at the member state level. So Greece guarantees the deposits in its banks up to 100,000 Euros. Of course, Greece (unlike the US federal government) has no ability to actually print Euros on demand. That means most bank customers treat its deposit insurance with justified skepticism. Greek banks too cannot count on the European Central Bank to lend to them freely in a crisis. There is an emergency lending facility, but it works through the member state central banks and let’s just say relations between Greece and the ECB are not exactly amicable at the moment.

These two factors taken together explain the phenomenon of Greek pensioners queuing for hours to withdraw the maximum amount permitted from their bank accounts each day (60 Euros). They do not trust the funds will be covered by deposit guarantees and Greek banks are limiting withdrawals, afraid they will run out of Euros.

As a study in contrasts, we have Puerto Rico, which is facing a similar government debt crisis, largely brought on by similar factors (mismanagement, misstatement of financial data, etc.). Yet, the impact is limited to the government’s ability to issue more debt and the value of its bonds. Puerto Rico’s bank will face no runs and will continue to function even if the government runs out of money. They are regulated and insured at the federal level. So, though Puerto Rico’s debt crisis is very serious, and will likely require some level of write downs, its banking system continues to hum along and is not at risk. If the European Union had a similar bank deposit guarantee system, we believe the Greek crisis would not have been as severe.

Lastly, what makes the Greek case significant and holds the market’s attention is not the size of Greece’s debts, which at around 300Bn are large, but not enormous. A 30% write-down of those debts would be 100Bn, some individual banks took write-downs in the 30-70Bn range during the financial crisis. Clearly Greek creditors (EU countries for the most part) could survive a 30% write-down.

What concerns the markets is that the Greek crisis lays bare an uncomfortable truth. The European Union is both unable, and unwilling to act decisively or with coordination in a crisis. The reasons are myriad, but to us, it has been particularly striking to hear World War I and II era rivalries and events repeatedly invoked by some commentators and even senior politicians. A skeptical observer might say that the institutions created to avoid the recurrence of war on the European continent seem to be hell-bent on re-living them. In contrast, though, we in the United States have had the traumatic experience of reliving civil war-era animosities over the past few weeks, those fervently invoking a North/South divide are firmly in the fringe and have been for at least a century. The same cannot be said of Europe.

We have been wary of asset prices and debt burdens within China for a number of years. Some of those concerns have bubbled to the surface in the last few weeks as the Chinese domestic market has endured a series of dramatic losses with many stocks hitting their down limits and several have halted trading entirely. Companies can also ask to suspend their own shares and many have. Most observers have expected such a crash since the on-shore Shanghai market has risen over 75% this year. What was underappreciated is how much of this rise has been driven by large numbers of first-time retail investors, many of them buying stock on margin (borrowed money). The conditions appear to resemble the state of the US market on the eve of the 1929 and 2000 stock market crashes. In certain ways, there are broader parallels with 1929. China is at roughly the same stage of relative development with the US that the US was to the UK in 1929. China has also seen massive investment in capital infrastructure with declining returns, not unlike the US investment in railroads in the 20s. Lastly, there are large quantities of questionable loans on the books at Chinese banks. Taken together, this story is much bigger and could have much wider repercussions than that just a few down days in a large emerging market.

The final consideration is political. Though there is a lot of tittering at the prospect of the Communist party attempting to support the stock market, this is driven by legitimate fears of political unrest if a severe downturn were to materialize. Coupled with factionalism within the party, such a downturn could make for a very volatile period in China, politically speaking. The impact is likely to be felt across commodity sectors (where China remains a major consumer), and a risk of contagion to other markets. In the short term, we expect the US markets will be seen as a relative safe haven. Though clearly, as one of the three largest economies in the world, any Chinese downturn will affect global market values.

On balance, we view the bursting of the Chinese equity bubble and antecedent effects as more significant than the Greek debt crisis. In terms of wealth impact, they certainly are — the Chinese stock market has lost over $3Tn over the past few weeks. That is ten times the amount of outstanding Greek debt. Margin balances owed by Chinese investors are larger than Greek debt. The real concern, though, is that the stock market bubble in its rise and fall, may lead to a bigger reckoning of Chinese financial institutions which are holding real-estate and provincial debt. As the real-estate sector has slowed, demand for land, which constituted a crucial source of funding for Chinese provinces, has dried up. Both real-estate developers and Chinese provincial government debts are looking very weak and they are widely held by Chinese banks and investors.

In general, we recommend appropriate caution for investors. Though the US markets may appear to be isolated from events in Europe and China, and might even benefit from some short-term “flight to safety”, they will eventually be impacted, and current valuations stateside do not bode well for that reckoning.

We continue to believe that investors will be well served to reduce exposure to risk assets in their portfolios and move some money into short term bonds and cash while awaiting a better buying opportunity.

2015 Investment Themes: The bells that toll

2015 Investment Themes: The bells that toll


  1. If not now, when? If not the Fed, who?: We expect the Federal Reserve to raise interest rates in 2015. We expect rates to gradually rise to a 1.0%–1.5% target, which would still be historically low. Short term rates after the tech wreck and 9/11 were kept below 2.0% for 3 years. For one of those years, rates were at 1.0%. Since the financial crisis of 2007/2008, rates have been kept below 0.25% for over 6 years. Both the level of the rates and the duration of the rate cut is extraordinary.


  1. No one rings a bell at the top of the market: US stock markets ended the year at almost three times the lows reached at the bottom of the market less than six years ago. We expected sharp corrections last year that failed to materialize. We are renewing our call this year and urge equities investors to exercise caution. And while we recognize the US stock economy looks healthier than those overseas, we expect major US indexes (S&P 500, Dow Jones, Nasdaq) to finish the year in negative territory.


  1. Emerging troubles: Emerging economies will continue to stumble in 2015, this includes resource dependent countries such as Russia and Brazil which have run into roadblocks as energy prices have fallen dramatically. The challenges are different, but as impactful for economies with internal imbalances created by over-investment in infrastructure such as China, and those facing enormous upheaval and political instability like Turkey. In the Chinese case, we are particularly concerned about the state of local and provisional government finances. We expect emerging market stocks and bonds to underperform developed markets this year.


  1. Commodities weighed down: With a slow-down in emerging markets and the global economy in general, we expect commodity prices to continue to come under pressure. While prices in certain commodities may stabilize, we do not expect a bounce back to levels seen in recent years.  We see commodities finishing the year flat to negative.


  1. The trouble with oil: We do not expect oil prices to substantially recover in 2015. It is clear that major OPEC participants in the middle-east are keen to minimize the profitability of oil as a source of funding for rebel groups in the region. They are also responding to medium-term strategic threats from unconventional oil producers (shale, deep sea, and tar sands) by forcing prices to levels that makes investment in such projects unprofitable. Continued unrest in major oil producing regions (Middle East, Russia, Venezuela) does not seem to have impacted supply or prices. We expect brent crude prices to remain under $60 by year’s end.


  1. Playing defense: For US equities, we believe defensive sectors, including healthcare and utilities will outperform others over the course of 2015. In any sort of correction, we expect enterprises providing essential goods and services to maintain profitability and revenues. Over-levered companies that have benefitted from speculative euphoria in recent years are particularly vulnerable to sell-offs in our view.


  1. Euro Crisis, back to the future: The Euro and Greek debt crises have faded from world news headlines over the past three years. A series of loans by the EU and IMF have succeeded in bringing down interest rates on Greek debt. In the past two months, however, a confluence of factors have roiled European markets. An impending election and veiled threats to renege on prior commitments by the party leading in Greek polls (Foriza) weigh heavily. We also expect court rulings on whether the European Central Bank can follow in the Fed’s footsteps with quantitative easing . Depending on outcomes, another round of brinksmanship will likely begin between Greek politicians, the markets and EU officials. Over the past few years, attitudes have hardened and we believe there is a real chance that Greece may be forced to, or choose to leave the Euro.


  1. Junk bonds get kicked to the curb. If, as we expect, interest rates rise over 2015, the long winning streak of high yield bonds will likely come to an end.  Junk bonds have benefitted from the Fed’s zero interest rate policy as savers have been forced to invest in increasingly lower quality bonds in order to find yield.  With rates rebounding (even marginally), we believe investors will find the reward that comes with high yield bonds no longer worth the risk.


  1. Growth in Renewables: 2008 saw high flying clean energy stocks taken to the wood shed when oil prices collapsed.  The thinking then was that renewables were not viable in a world flush with cheap energy.  While that thesis made sense seven years ago, the renewable industry has grown in leaps and bounds since.  Utility scale solar and wind projects have proven to be viable sources of energy as costs have come down and demand for renewable power has increased globally.  With oil prices falling again, we’ve seen many renewable stocks follow suit, as sort of a knee jerk reaction by investors.  We think this provides a tremendous buying opportunity, particularly in the YieldCo space where, like utilities, companies own a portfolio of newly constructed power projects with long term power purchasing agreements in place.


  1. The Russian question: 2014 has been a disorienting year for Russia. Ukraine, a neighboring state with long historical ties to Russia saw enormous unrest leading to a revolutionary change in government and the potential breakup of the country into Eastern and Western factions. Russian forces occupied and appear to have annexed the region of Crimea. Meanwhile, declining oil prices have placed substantial pressure on Russian public finances and may begin to erode support for Mr. Putin among both the grassroots and his oligarchic supporters. It is difficult to see non-traumatic paths out of the morass. Under Putin’s leadership, Russia’s structural problems (declining population, aging industrial base, and undiversified economy) have become worse. We are bearish on Russia and expect the Russian market to underperform in 2015.
2014 Themes: Year-End Review

2014 Themes: Year-End Review

2014 Themes: Year-End Review


  1. × The bond decline continues: …The 20 year treasury began 2013 at 2.63% and ended the year at 3.70%. We wouldn’t be surprised to see it exceed 4.50% by the end of 2014….  We were flat out wrong on this prediction. Increasing uncertainty overseas drove demand for treasuries that was not countered even by the unwinding of the Fed’s bond buying program. 20 year treasuries ended 2014 at 2.49%, while the 30 year was at 2.76%.


  1. × Equities: Last Call at the QE punchbowl …These will put a lot of pressure on stock prices. With multiples at cyclical highs, conditions are ripe for a significant correction, especially in US markets. We advise investors to avoid complacency and prepare for a potential 20%+ correction in 2014.  We were wrong on this prediction as well. The S&P 500 ended the year up almost 13% and earnings were at an all-time high for the index.


  1. ? Bitcoins backlash: …Despite the concerted efforts of many conspiracy theorists, we do not see a major reckoning for fiat currencies in the offing and therefore continue to caution against allocations to alternative or commodity based currencies. We were right on this call. Bitcoin prices fell from over 750 at the beginning of 2014 to start 2015 under 300.


  1. ? Social Media Mania: …We are long-term believers in the transformative potential of technology, but do not believe current valuations are anywhere near reasonable. Investors will have to be a lot more selective in 2014 if they are to avoid the kind of fall we saw in the early 2000s. We expect to see several of these high-flying tech IPO darlings come back to earth this year. A number of 2012 and 2013’s high-flying social media IPOs saw prices collapse, this included companies like Twitter, Yelp, Zynga, Groupon. Others like Facebook and LinkedIn retained or regained their heights.


  1. ? Go Global or Go Home: …We believe media companies with strong properties are on the cusp of another period of growth in market-share. At reasonable valuations, they represent an attractive long-term investment. At the same time, we believe strong regional, cultural media properties will also find traction in their home markets and any areas with affinity. This is more of a long-term prediction and we expect to evaluate it over time.


  1. ? Commodities Wane: Commodities, for the most part, have been in a relatively flat holding pattern since the 2008 bubble. We expect commodity prices to remain weak or stagnant throughout 2014. We do not anticipate large rises in economic activity in the offing, which means commodity prices will remain depressed.  We do not expect gold or other precious metals to recover and anticipate further declines. We were right on this call, almost spectacularly so on oil, which fell almost 50% to under $60 a barrel. Gold was largely flat. The S&P/Goldman Sachs Commodity Index lost 35% over the course of the year.


  1. × Wages and Profit: The past few years have seen corporate earnings rise while average wage income has stagnated along with labor costs as a portion of GDP. We expect 2014 to reverse some of this trend as a declining unemployment rate and an evolving political climate make for higher wages and a higher minimum wage floor. We believe this will put pressure on industries and companies that rely on a large, low-paid work-force. After-tax corporate profits as a percentage of GDP rose to over 10% during 2014. This is higher than at all previous periods in US history. The last period that came close was 1929, the eve of the Great Depression when they reached 9.1%. Pre-tax corporate profits hit 12.5%, tying the prior high set in 1942 when companies benefited from increased demand for industrial goods as the US entered World War II.


  1. ? Health-Care Strengthens: Gains in the Health-Care Index have outpaced that in the broader markets by about 10% in 2013. 2014 is the first year the impact of the Affordable Care Act will be felt in revenues of insurers and health-care providers. We expect health-care revenues will rise and the sector will continue to outperform the broader market this year as well.  The S&P healthcare service index rose over 24% during 2014. The healthcare equipment index rose over 18%. Both handily exceeded the overall S&P gain.


  1. ? Atlantic tug of war: The Euro has appreciated against the Dollar over the course of 2013, as the European fiscal crisis has been pushed off center stage. We believe the Fed’s tapering will reverse this move and we will begin to see the dollar appreciate as rates rise in the US. We were right on Euro valuation, the Euro fell over 12% during 2014 to end the year under 1.20.


  1. ? Water Works: We have been concerned about water-related infrastructure for a number of years. Most population growth is occurring in regions with limited access to large quantities of fresh water and this problem is more acute than any issues with power generation. We believe consumers and regional planners have begun to appreciate this as well and we will see a rise in investments directed towards water infrastructure. Major engineering companies and water utilities should benefit, as will firms with consumer products that improve efficiency.   While we view this as a long term investment trend, 2014 saw US water-related stocks substantially outperform the S&P 500 index.  The Dow Jones US Water Index was up 24.67% for the year.
2014 Q3 letter: Rates and Revolutions make the world go ’round

2014 Q3 letter: Rates and Revolutions make the world go ’round

The summer of 2014 has been one of revolutions with unrest spreading across much of Central Asia and the Middle East. Towards the end of September, we also saw a protest movement begin to take hold in Hong Kong. The common thread running through so many of these events is the democratic aspirations of a younger generation—a generation that, through the use of social media, now has instant access to much of the world’s current events and can compare the conditions of their own country with the rest of the world. When this comparison highlights unresponsive, ossified political and economic institutions, this generation demands change. This is happening in ways both big and small, and the United States is not immune as we can see from the manner in which the protests in Ferguson, MO snowballed. In a very real sense, these events are a testament to the radical advances in personal communication technology made over the past few decades. It is also a testament to the soft power of the world’s market-oriented democracies, which are viewed as a role-model by much of the world.

Change though, is by definition disruptive, and these revolutions, both big and small, are no exception. The most violent ones in the Middle East and Ukraine have disrupted life and trade in many ways. The destruction of human and physical capital will, in many countries, take years to mend. US markets have seemed immune to these political events, but that can change quickly.

For investors, the bigger question is in the timing of Federal Reserve’s next steps. Over the course of 2014, the Fed has unwound its highly unusual program of bond purchases. These purchases have helped buoy the bond markets and kept long-term rates low for an extended period. These historically low rates have allowed many creditors to refinance medium and long-term debt at attractive terms. Meanwhile, an unprecedented program to keep short-term benchmark rates at near 0% has helped banks shore up balance sheets and spurred some investment. As bond investors well know, low yields on the safest investments have pushed many into investments riskier than they would otherwise tolerate.

Since late 2007, the Federal Reserve has used every tool in its arsenal to shore up business conditions in the US. They have also developed new ones (including bond purchases that expand the Fed balance sheet) and radically expanded the scope of traditional methods. The most unorthodox of these policies have been almost completely unwound (the Fed is expected to officially end its bond purchasing program on Oct 29th). What is left is an unusually low short-term interest rate and large bond holdings which will roll off over time. In previous public comments, Federal Reserve governors have said they will carefully consider labor market conditions before amending the current interest rate policy. The market has widely read this as waiting for a headline unemployment number under 6%. Headline unemployment as reported on October 3rd was 5.9%. Though most observers agree the labor market is still not robust—which is apparent when we see the extraordinary numbers of discouraged and involuntary part-time workers—we have had zero rates for nearly six years now and many on the board of governors are uneasy with that length.

The US election cycle may play a role in the timing of an interest rate rise, but we do not expect the Fed to move before the upcoming midterm election in November. Similarly, we do not expect them to move rates dramatically in a presidential election year. This means 2015 might be the best opportunity for the Fed to gradually bring rates up from 0% to some nominally “normal” level (say 2.0%) and then pause to take stock and wait out the election. In our view, this is the likeliest scenario, absent another major market upheaval.

Since 2009, the winding down of Fed stimulus programs have led to selloffs in equity markets. We expect Oct/Nov of 2014 to be no different and recommend clients remain defensive with their allocations. If the Fed is serious about ending further stimulus, the stock market will need to stand on its own two feet. Given recent record highs, we are skeptical that equity prices will continue their meteoric rise in the absence of Federal stimulus and with the threat of impending rising interest rates on the horizon. 2014 has already seen the beginnings of a correction in more speculative stocks (the Russell 2000 small cap index is down approx 5% year-to-date through 9/30 and down nearly 10% since its peak in early July). If we see a correction, we expect there will be buying opportunities where quality companies can be had at discount prices.

In other news, after 5+ years of residing in the Flatiron area, we have recently relocated our office to Midtown. Our new contact info is as follows:
261 Madison Ave, 10th Flr
New York, NY 10016

Tel: +1.646.450.9772
Fax: +1.929.244.0256


Subir Grewal                                               Louis Berger

2014 Q1 Letter: High Frequency Trading and the average investor

2014 Q1 Letter: High Frequency Trading and the average investor

Dear Friends,

The first quarter of 2014 saw an uptick in stock market volatility as a change in Fed leadership and Russia’s annexation of Crimea caused some investors to rethink investment and trading positions. The Dow Jones Industrials finished the quarter -0.72%, the S&P 500 +1.3% and the Nasdaq 100 was +0.54%.

Meanwhile, after a poor showing last year, bonds bounced back in Q1, outperforming equities. The Barclays Aggregate Bond Index finished the quarter +1.97% while the Barclays Municipal Index saw gains of +3.32%.

Though these movements are not large, there have been significant moves in particular sections of the market. In 2013, certain internet and biotech stocks rose to excessively optimistic valuations, but 2014 has seen particular weakness in these names. We believe this indicates the broader market is nervous to some degree about growth prospects with many participants taking profits in what they perceive to be the weakest and most speculative names.

The dramatic events in Ukraine have also jittered investors, particularly those exposed to Russian assets or consumption. The risk of rising tensions and economic sanctions against high-spending foreigners has depressed luxury goods makers and brought a chill to higher end real estate in major global metropolis. At the same time, we have seen Chinese investors and companies spooked by falling demand and regulatory actions in China.

January saw Janet Yellen officially step into her new role as Fed Chair, replacing the departing Ben Bernanke. In March, she held her inaugural press conference, which seemed to go well, until she was asked a follow-up question about when she expects interest rates to be raised. She had used the term “a prolonged period” which a reporter asked her to clarify.

Unlike her predecessors, who would have either ignored the follow-up question or provided a maddeningly vague answer, Yellen, in what may have been an attempt to shed light on the traditionally opaque Fed, answered “It’s hard to define but, you know, probably means something on the order of around six months.” US stocks immediately sold off on this comment, as investors interpreted this to mean that the Fed’s easy money policy would end sooner than originally thought.

This incident reinforces our view that markets have become far too reliant on the Fed’s easy money policy. We expect risk assets (namely stocks) will continue to be under pressure as the Fed winds down its stimulus program.

High frequency trading has been in the news over the past several weeks with the release of a couple of high profile books that delve into the guts of the equities marketplace. The steady demise of physical trading floors and the advancement of technology has moved virtually all trading volume onto electronic venues. Inevitably, the vast sums at stake have led to an arms race amongst trading firms. We’ve known for some time that major market-makers have been doing their utmost to gain physical proximity to exchange computers so they can see orders as quickly as possible. The exchanges (which have over the past fifteen years transformed themselves from member-owned organizations to for-profit publicly traded corporations) have not been shy in tapping this new revenue stream. In our view, this is not any different from the old days when traders who participated in the market would buy an exchange membership so they could walk onto the floor and be in the middle of the action. There was an informational advantage to seeing the activity of the actual participants on the floor, this advantage still exists, but the venue is electronic. Most investors will never have cause to consider high-frequency trading or being part of the market on an exchange floor. This is highly specialized activity requiring very specific skills, which is why exchange memberships were limited, and why there are only a few successful HFT firms.

The move to electronic market-making has been largely beneficial for investors. Costs to execute transaction have fallen. Investors who would pay brokerage commissions in the hundreds of dollars now pay a handful of dollars for the same. But the far larger impact has been on bid-offer spreads, the difference between the price at which the market is willing to buy and sell a particular stock. With decimalization, these have fallen from one-eight or one-sixteenth of a dollar down to a cent or less in most cases. Most individual investors will not generate orders that are the target of HFT algorithms since they are too small to generate predictable patterns.

What has changed, and does concern us, is that some exchanges are changing rules at the behest of HFT firms. There has been a profusion of order types for interest, the vast majority of these are not used by the average investor (of any size). They’re exclusively used by the programs run by HFT shops to discover what market participants are doing without running afoul of securities regulation. In a sense, the exchanges have been responding to customer demand, since much of their revenue now comes from HFT firms, but this is short-sighted. The true clients of stock exchanges are the investors and listed companies (and by extension the investment advisors and brokers who represent them). Prior to de-mutualization, leadership at exchanges knew this and balanced the interests of their members (who were on the floor every day trading and making markets) and those of investors and corporate issuers. It seems this balance has been skewed and some electronic exchanges may have become captive to the interests of the firms who generate the most revenue for them. This short-term thinking, and the belief that obeying the letter, rather than the spirit of our laws (which broadly aim for investor protection) is what worries us.

In other news, we recently hired a new intern named Daniel Sobajian. Daniel comes to us from Columbia University where he’s majoring in political science. Daniel is also founder of, a non-profit he started while in high school that provides school supplies to needy students in southern California.

Louis recently published an article on the website The article investigates the risks of investing in crowd-sourced clean energy projects, specifically Solar Mosaic. You can read the article by logging onto and running a search for Louis Berger.

Louis Berger                                                                    Subir Grewal